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Closing Out The Amedisys/LHC Group Pair Trade Recommended In February 2019

|About: Amedisys, Inc. (AMED), LHCG

This posting officially recommends closing out the pair trade recommended in February.

We review some math on calculating returns.

On 2/27/19, Seeking Alpha published my article (supported by two blogs) recommending a short position in Amedysis with a simultaneous and equal long position in LHC Group. This is called pair trading and is a form of arbitrage.

I had set some parameters around when to exit the trade: either by 7/1/20 at the latest, or much sooner “if the Amedisys market cap premium gets to within 11%” of that of LHC Group. As of today, the market caps have inverted: LHC Group now commands a premium in relation to Amedisys. In other words, this trade quickly went extraordinarily well.

From a slightly broader time perspective, the turnaround in relative market caps has been stunning. On 12/3/18, Amedisys’ market cap ($4.58B) was 41% greater than that of LHC Group ($3.25B); as of 5/17/19, LHC Group’s market cap ($3.68B) is 3.6% greater than Amedisys’ ($3.54B). Anyone lucky enough to have entered and exited this trade at exactly those times would have achieved monstrous returns.

Of course, it is foolish even to attempt picking the best entry and exit prices. We are simply trying to benefit from substantial mispricings. If we are lucky enough to time our transactions perfectly, great; but that is not the goal.

I posted this pair recommendation on 2/24/19,[i] using the two stocks’ closing prices of 2/22/19, which put Amedisys’ market cap ($4.21B) 22% greater than LHC Group’s ($3.45B). I then made a comment under the published article (which would have been automatically messaged via Seeking Alpha to any of my followers) that I cleared the pair trade on 5/1/19, when Amedisys’ market cap ($3.93B) was 14% greater than LHC Group’s ($3.43B).

In hindsight, I clearly should have waited. Hindsight is a helpful teacher. Unfortunately, there are no do-overs for those of us who have already executed a trade.

For those of you still holding onto this trade, good for you. The trade went from great to unbelievable over the past few weeks. But I suggest exiting at this point. As explained in my original recommendation, Amedisys could sell itself at any point, which would result in an adverse outcome for this trade. Plus, we are only about seven weeks away from CMS advising of likely changes to the industry. In anticipation of bad news from CMS, short sellers will be increasing their stakes in these companies soon—negatively impacting the price of both stocks. While I didn’t cover this nuance in the recommendation, it is important to note here on the exit side that other factors being equal, higher prices of the paired securities provide superior results. Moreover, pair trades don’t require any of your own capital, but they do require the use of margin, which means borrowing costs can eventually add up. And finally, after only 12 weeks, we achieved the highest end of my outlined goals: an inversion (LHC Group’s market cap is greater than Amedisys’). Those reasons all add up to a solid argument to take our money off the table.

How do we calculate returns on pair trades? Let’s say a hypothetical investor initiated the trade by shorting 780 shares of Amedisys at $128.84 on 2/24/19 and in doing so received $100,495.20 of someone else’s money. She then took $100,455.00 of that money and bought 905 shares of LHC Group at $111.00. Let’s pick two hypothetical exit dates for our trader: 5/1/19, for those traders who moved too early (like me); and 5/20/19, the first trading day after this blog’s posting. Here are the hypothetical profits for each of those two dates:

5/1/19 total profit is $6,296.61 (a $6,795.36 gain on the Amedisys side of the pair, and a $497.75 loss on the LHC Group side).

5/20/19 is $22,551.25 ($15,990.00 on the Amedisys side, and a $6,561.25 gain on the LHC Group side).

Some might argue that the above profits represent the numerator for our return equation, while the denominator is the $100,495.20 from the Amedisys short sale. But while it’s true that that $100,495.20 was involved in the investment, it wasn’t our invested capital (see Short Explanation for more details on short sales).

In order to execute the trade, our investor’s brokerage required her use of a margin account that charged, say, 5% interest on that $100,495.20. Let’s see what the interest charges look like using our two hypothetical close out dates.

5/1/19 total interest charged is $921.21.

5/17/19 total interest charged is $1,158.49.

Those interest charges certainly count as our trader’s equity, so we could calculate return on equity (ROE) for each closing date as shown below.

5/1/19 ROE = $6,296.61/$921.21 = 684% in 66 days, or 3,780% annualized.

5/17/19 ROE = $22,551.25/$1,158.49 = 1,947% in 79 days, or 8,994% annualized

Those are impressive returns.

However, my preferred method of thinking about margin trading returns is to add the net results on top of non-margin annualized returns. For example, using our hypothetical trader from above, if she started 2019 out with $500,000 in total assets in her brokerage account, and finished the year—having made no withdrawals or contributions—with $550,000 sans margin activity, then she netted a 10% return. But if she also netted $10,000 in profits from her margin account (after subtracting interest charges), then her net 2019 ending assets are $560,000, which means her margin activity added 2% to her total annual return. Stated differently, without the margin account, she gained 10%; with it, she gained 12%. The margin activity in this example, therefore, boosted her gains by 20% (from 10% to 12%).

Of course, such super-charged outcomes can go either way—hence my perennial warnings about the use of margin lending.

[i] I initiated this trade in late November ’18, then submitted an application to join Joel Greenblatt’s Value Investor’s Club using this pair trade as my recommendation. I was rejected. Still, I continued accumulating the paired positions until one week before releasing the three articles.

Disclosure: I am/we are long LHCG.